Question

Blue Creek Industrial Inc. is considering updating its production process. The managers are considering replacing a machine which it purchased four years ago with an installed cost of $620,000. There are 2 years of depreciation remaining using the MACRS rates given below. The new machine, a BIOVAT 3000, will cost $900,000 and will require an additional $29,000 for delivery and installation. This new unit will also require training costs of approximately $11,000. The MACRS rates are 20%, 32%, 19%, 12%, 11%, and 6% for years 1 through 6 respectively, and the marginal tax rate is 34%. The old machine is expected to be sold for approximately $320,000 today or $38,000 ten years from now.

            If BCI purchases the new equipment, annual revenues are expected to increase by about $47,000 per year, however, the expenses are expected to decrease from $42,000 with the old equipment to $27,000 with the new machine in the first year. Beyond that, the company’s expenses are expected to be an additional $3,000 less per year. Since the new machine is expected to be more efficient, net operating working capital (mainly due to required inventory) is expected to fall by $4,000 at the outset of the project and remain at that new level through the duration of the project.

a) (8 points) Calculate the year 0 cash flow which would be used for capital budgeting purposes.

b) (8 points) Calculate the year 1 net cash flow which would be used for capital budgeting purposes.  

Answer 1

a)	Cost of the new machine, including installation cost		$    -9,29,000.00
	Sale value of old machine	$    3,20,000.00
	Book value of old machine = 620000*17% =	$    1,05,400.00
	Gain on sale	$    2,14,600.00
	Tax on gain at 34%	$       72,964.00
	After tax sales proceeds of old machine = 320000-72964 =		$      2,47,036.00
	Net cost of the replacement		$    -6,81,964.00
	After tax trainng costs = 11000*(1-34%) =		$          -7,260.00
	Reduction in NWC		$            4,000.00
	Year 0 cash flow		$    -6,85,224.00
b)	Increase in revenue	$       47,000.00
	Decrease in expenses (42000-27000)	$       15,000.00
	Incremental depreciation:
	New machine = 929000*20% =	$    1,85,800.00
	Old machine = 620000*11% =	$       68,200.00
	Incremental depreciation	$    1,17,600.00
	Incremental NOI	$      -55,600.00
	Tax at 34%	$      -18,904.00
	Incremental NOPAT	$      -36,696.00
	Add: Depreciation	$    1,17,600.00
	Year 1 net cash flow	$       80,904.00